The Slutsky Equation in Microeconomics - dummies

The Slutsky Equation in Microeconomics

By Lynne Pepall, Peter Antonioni, Manzur Rashid

Put simply, the Slutsky equation says that the total change in demand is composed of an income and a substitution effect and that the two effects together must equal the total change in demand:

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This equation is useful for describing how changes in demand are indicative of different types of good. Indifference curves are always downward sloping, and so the substitution effect must always turn out to be negative. But the income effect may not be, depending on how consumption of a good changes with income.

A normal good has a negative income effect, and so if the price goes down and hence purchasing power or income goes up, then demand goes up. The reverse holds when price goes up and purchasing power or income falls, because then so does demand.

But not all goods are “normal.” Some are inferior in an economic sense. That doesn’t mean that they’re of poor quality but that they have a negative income profile — as income goes up, a person consumes less of them. Instant noodles, for instance, aren’t generally held to be a product that people consume unless they’re constrained in terms of money; as you get richer, you consume less of them. In this case, the substitution effect is negative, but the income effect is also negative.

Although unusual, there are some cases where extreme trading down occurs so that as income goes down, the income effect is positive and the total change in demand turns out to be positive. These goods are known as Giffen goods, after the economist who first investigated their existence during the Irish famine. As the price of potatoes went up, so did their consumption. Giffen goods are often thought of as curiosities, but they do exist, albeit as a small subset of the total set of inferior goods.